Cap Rate Crazy?
Is Direct Capitalization Pushing Values Even Lower?
In today’s market, investors, lenders with REO assets, and property owners are trying to maintain as much value as possible in commercial investment property sales. Appraisals are the first step in that process. Appraisers determine value either by comparing similar sales in the market — difficult to do in this time of so few sales — or by employing the income approach to value. When using the income approach, appraisers can provide valuations using the direct capitalization method or a discounted cash flow analysis through yield capitalization.
Today, many commercial appraisers are providing valuations using direct capitalization for commercial properties in their income approach to value. In my opinion, this has led to lower property valuations than necessary. Recently I have received telephone calls from lenders in the marketplace inquiring as to why the sales comparison approach to value and the income approach to value are so severely spread apart.
The gulf between the two methods is a function of the use of direct capitalization. (Direct capitalization is applied by dividing net operating income by a market derived cap rate. Income / Ro = Value.) Direct capitalization is a great process in a stable marketplace; however, it fails to reflect changes in market conditions. In these times of economic turmoil, investors and owners are leasing at lower rates short-term with the intention of mitigating holding costs until the market returns to positive territory.
The inherent weakness of direct capitalization is that the process does not take into account market cycles or idiosyncrasies of present conditions. It is not realistic to consider or assume that the typical commercial property investor will hold a property for a single year. So how is it realistic to determine value based upon a single year’s anticipated income and expense?
Direct capitalization also neglects factors such as short-term leasing with an anticipated rent bump or re-leasing as economic conditions improve, implications of current property tax rates, and the general overall cost of ownership. To arrive at a reasonable opinion of value, these and additional factors must be considered.
In this appraiser’s opinion, direct capitalization is reverse engineering at its finest. To extract capitalization rates from recent sales in the marketplace is the process of determining net operating income after the fact. Most notably, the majority of cap rate information does not include the most necessary data required to be fully credible -- lease rates, lease terms, renewal options, strength of tenant, motivations of seller/buyer, and, most importantly, how the comparable NOI was calculated. Thus it reflects a roll-of-the-dice analysis for a majority of reported rates.
Although a discounted cash flow analysis typically includes more assumptions, it allows one to apply differing assumptions allowing for varying scenarios (optimistic, less optimistic, and pessimistic). A well-thought-out market analysis will indicate a much more thorough set of assumptions. However, some assumptions are giveaways. With some property types exhibiting decreases of over 50 percent in value currently, it would be fairly predictable to determine a potentially substantial decrease in property tax and what effect this might have on a multimillion-dollar property valuation.
I cannot emphasize enough the value of the CCIM education in providing an understanding of the typical investor’s approach. This education has allowed me to examine the contributing factors included in a commercial real estate investment decision.
The concept of the present value of projected future income is what determines the sales prices of properties today. Thus, appraisers should use a well-thought-out discounted cash flow analysis that considers market cycles, potential decrease in tax rates, vacancy costs, and other factors.
Understanding the weaknesses of direct capitalization will help sustain reasonable commercial property values in the current marketplace. When the sales analysis and the direct cap analysis are so far apart, it is the instinct of a fair portion of commercial appraisers to start lowering their indication of value through the sales comparison approach and start raising their value through the income approach until a reasonable spread is reached. Appraisers can help preserve the commercial marketplace by leaving the sales comparison approach alone and applying the most educated assumptions possible in a well-thought-out discounted cash flow analysis.
In my experience within the past year of changing market conditions, a well-thought-out discounted cash flow analysis typically is running approximately 5 percent to 10 percent below current sales pricing. That is a spread I can live with. I always run a direct cap rate as well, but I usually state or imply a severely decreased reliability or pull it out of the report so as not to mislead clients.
For lenders, brokers, and other market participants, it is most important to understand this concept. If this process had been understood and applied in 2005, we would not be neck deep in the commercial real estate muck today — maybe just ankle or knee deep.
I just read "Cap Rate Crazy" in the May/June 2010 issue of Commercial Investment Real Estate, which compares the direct capitalization and discounted cash flow methods of valuation, and found it to be misleading to those who wouldn’t know better.
The author explains that the "weakness of direct capitalization is that the process does not take into account market cycles or idiosyncrasies of present conditions. It is not realistic to consider or assume that the typical commercial property investor will hold a property for a single year. So how is it realistic to determine value based upon a single year’s anticipated income and expense?"
This criticism is valid only if the direct capitalization method is done improperly. There are mechanisms to adjust for atypical vacancy or concessions in the first year of a cash flow so that the direct cap is not misleading. A "gulf between the two methods" as described by the author, is an indication that something was done incorrectly in one or both.
Furthermore, the overall rate (OAR or cap rate) derived from a sale DOES take into account the buyer's (and assumed willing seller's) perception of where the sale property resides in a particular market cycle, as well as that market's "idiosyncrasies." The rate is a concise commentary from market participants on future rent growth, vacancy, concessions, etc. And the behavior of market participants is what an appraiser should be reporting.
Lastly, in advocating the discounted cash flow method (DCF), the author fails to mention an important point. The value derived from the DCF method is really a sum of present values of future cash flows over a selected holding period — often ten years. The largest cash flow, typically representing around 50 percent of a property's total present value, comes from the last year of the holding period when a sale is assumed to take place. In addition to the cash flow generated during the last (say 10th) year of the DCF, the net proceeds from this assumed sale are discounted back to present value. How are these net proceeds determined? Yes, by the direct cap method.
In other words, the author appears to feel more comfortable applying direct capitalization to income projected ten years from now, rather than relying on what's available currently in the marketplace. I don't.
Each method has its virtues and limitations, and both need to be done properly to be useful in the appraisal process.
Thomas R. Gould, Jr., MAI
Hello Mr. Gould,
Your points are well taken. The point that I am trying to emphasize is that in my experience, I see very few commercial appraisers that do diligent research in deriving reliable cap rates for direct capitalization or are able to quantify any necessary cap rate adjustments.
Additionally, in the marketplace in which I am located, a fair portion of owners are currently leasing at unsustainably low rates short term. See what response you get from a lender when you apply DC to these properties with the current rates. It is not reasonable. However, as you state, there are merits to both processes. Of course, garbage in/garbage out.
Most people that I discuss this issue with have a strong opinion one way or the other with few in between. I know where you stand!
Thanks for your comments.
Brian Frank, CCIM, GAA
Another Reader's Response
I am responding to Mr. Frank’s article, "Cap Rate Crazy." As an investor and landlord manager, I believe Mr. Frank is spot on. Discounted Cash Flow is the underlying method for evaluating any investment, including the real estate asset class.
When evaluating an office/retail property, each lease should be discounted according to a tenant’s creditworthiness, term, probability of renewal, etc. At the property level, the income is affected by financing costs, projections of overall vacancy rates, rental market, amount and timing of nonreimbursable expenses, and reserves. Estimating a realistic sale price is always tricky and has to be balanced by appreciation and future Net Operating Income assumptions.
After quantifying these assumptions, the investor can then compare the property’s Internal Rate of Return against his own required rate of return. To meet the targeted rate of return, the investor could singularly or in combination offer to pay a lower price and increase positive cash flow and resale through strategies such as expansions, renovations, re-tenanting, etc. Of course, if the numbers don’t work, then the investor walks from the deal.
Institutional deals involving long-term triple net leases with publicly traded corporations may trade using cap rates. However, individual investors base their decisions on some informal or formal DCF pricing. A good DCF model exposes a property’s unique risk. The days of unrealistically low, broad brush cap rates unadjusted for individual property risk, fueled by artificially low interest rates, and loaded with future appreciation assumptions are over (at least until the next bubble run-up!).
In addition to individual property risks, external economic risks such as unemployment, inflation, future interest rates, tax/regulatory changes, etc., loom large on the horizon. Anyone buying a medium to long term bond today not only has to worry about the probability of default but future interest rates.
I am not convinced that DCF will always lead to higher asset prices over cap rates; as internal and external risks are exposed, the investor will need to be compensated relative to other "safe" investments. We cannot avoid the basics of risk/reward.
William M. Schlossman